Explainer: What are Dividends?

When you purchase a stock in a company you become a part-owner of the business, and dividends are your share of the profits. However, not all companies pay out dividends.

So, how do dividends work and what are the pros and cons of investing in dividend stocks?

How dividends work?

When a publicly held company makes a profit the board of directors have to decide where the funds will go. Either the company retains the profits to invest back into the business or the decision is made to pay out dividends to shareholders. Sometimes, it can be a mixture of both.  When ASX listed companies decide to pay out dividends they generally do so biannually.  And this cash payment is usually a percentage of the profits relative to the number of shares you own in the company.

For example, let’s say that company XYZ makes a $10 million profit. The board decides to pay out 70% ($7 million) of the earnings and retain the remaining 30% ($3 million) for business expansion. The company has 1 million shares on issue. Therefore, each shareholder is entitled to receive a dividend payment of $7/share.

If a company has had a particularly profitable year dividends may even be increased. Generally, dividends are sent to shareholders either via a cheque or transferred by direct credit.

What are the pros and cons of dividend stocks

As not all companies pay out dividends, let’s breakdown the pros and cons of investing in dividends stocks so you can decide if they fit your investment portfolio.

Pros

Probably the biggest advantage of investing in a dividend paying stocks is that it’s the most common way of profiting from a stock without selling it. This can make dividends particularly attractive for investors looking for an income stream from their investments. If an income stream is not your primary objective than an alternative is to reinvest your dividends.

Additionally, when a company distributes dividends to shareholders this is seen as a positive sign for the company’s financial health.  If a company can afford to pay dividends to shareholders then in theory they should be making a profit. Better yet, if the company has consistently increased their dividends then they are likely to be a consistently profitable business. However, it is always best to pair this logic with thorough research and analysis.

According to ASIC’s Moneysmart website, dividends might also provide a bonus tax credit in the form of a franking credit. A franking credit arises when a company’s after-tax profits are distributed as dividends. These dividends are known as franked dividends and a shareholder receives a franking credit representing the amount of tax the company has already paid relating to those shares. Read more about it here.

Related article: 5 of the most common financial ratios

Cons

On the downside, companies that choose to reinvest their profits as opposed to paying dividends may grow faster. Their profits can instead be used to expanded the business, which over time may see the stock value of the company grow.

Also, dividends are not always guaranteed. When a company’s earnings fall, generally so do their dividends. At any point a company can choose to reduce or eliminate their dividends altogether. The argument can be made that if you are looking for a steady income stream a better option may be to invest in bonds instead. Generally less volatile than stocks, bonds commit to paying out a coupon (interest) to bond holders at regular intervals until the bond matures. Learn more about bonds here.

The last piece of the pie

Dividend stocks don’t suit all investors. Investors who are prioritising long-term wealth accumulation may want to focus on capital gains rather than on dividends. However, if you want to see results from your hard-earned money sooner rather than later, you may want to consider dividend paying stocks as part of your investment portfolio.

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